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Thursday, August 23, 2007

The Economist Magazine Asks a Troubling Question

The Economist magazine asks a troubling question: does America need a recession? The answer may at first seem an obvious 'No!', but looking back to the example of former Federal Reserve chairman Paul Volker tempers this conclusion. As chariman, Paul Volker in the early 1980s successfully engineered two sharp recessions that are credited with creating the stable macroeconomic environment important to the subsequent 20+ years of U.S. prosperity. Back during Volker's time the recessions were used to lick inflation, today the argument for a recession rests on removing the real economic distortions (e.g. housing glut) created during the 2001-2005 monetary binge.

"...But should a central bank always try to avoid recessions? Some economists argue that this could create a much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the Fed can prevent any future recession, consumers, firms, investors and borrowers will be encouraged to take bigger risks, borrowing more and saving less. During the past quarter century the American economy has been in recession for only 5% of the time, compared with 22% of the previous 25 years. Partly this is due to welcome structural changes that have made the economy more stable. But what if it is due to repeated injections of adrenaline every time the economy slows?

Many of America's current financial troubles can be blamed on the mildness of the 2001 recession after the dotcom bubble burst. After its longest unbroken expansion in history, GDP did not even fall for two consecutive quarters, the traditional definition of a recession. It is popularly argued that the tameness of the downturn was the benign result of the American economy's increased flexibility, better inventory control and the Fed's firmer grip on inflation. But the economy also received the biggest monetary and fiscal boost in its history. By slashing interest rates... the Fed encouraged a house-price boom which offset equity losses and allowed households to take out bigger mortgages to prop up their spending. And by sheer luck, tax cuts, planned when the economy was still strong, inflated demand at exactly the right time.

Many hope that the Fed will now repeat the trick. Slashing interest rates would help to prop up house prices and encourage households to keep borrowing and spending. But after such a long binge, might the economy not benefit from a cold shower? Contrary to popular wisdom, it is not a central bank's job to prevent recession at any cost. Its task is to keep inflation down (helping smooth out the economic cycle), to protect the financial system, and to prevent a recession turning into a deep slump.

The economic and social costs of recession are painful... [b]ut there are also some purported benefits... [o]nly by allowing the “winds of creative destruction” to blow freely [can] capital be released from dying firms to new industries. Some evidence from cross-country studies suggests that economies with higher output volatility tend to have slightly faster productivity growth. Japan's zero interest rates allowed “zombie” companies to survive in the 1990s. This depressed Japan's productivity growth, and the excess capacity undercut the profits of other firms.

Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt and a huge current-account deficit) in place. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a choice between a mild recession now and a nastier one later.

2 comments:

Presumably, if the FED had followed the Taylor rule under Greenspan 2001-2005, we would have had more sustainable macro and financial outcomes. So is the issue still one of an over-politicized central bank in the US ? No property boom craziness in Europe, courtesy of ECB sobriety!

An interesting question--I usually think of the political business cycle literature being applied to developing economies, but you are suggesting it may have more relevance here at home.

To the extent the Fed responds asymmetrically---will ease to prevent financial failure, but will never tighten to prevent financial imbalances forming--one could argue this bias is driven by a fear of potential political pressures (upset main street, upset wall street, and upset congress). Since no Fed official would ever admit to such as bias, if it does exist it may do so a subconscious level.

However, I suspect the more important factor is the Fed simply made the wrong calls over the past 5 years using shortsighted analysis.